To Avoid Big Losses, You Must Recognize The Limits Of Exponential Growth

I would like to thank those of you who endured the first installment in this 4-article series on overvalued businesses and have actually returned to subject yourselves to the second piece; I sincerely hope you both enjoy it.

In this, the second installment, I want to illustrate how valuations that were potentially reasonable on a smaller business become simply absurd when the business becomes large. One of my favorite ways to illustrate the difficulty of maintaining high growth rates as size increases is my tale of the compounding pennies. I use this example to illustrate to young investors the immense benefit of beginning wealth accumulation at an early age and sticking with a plan for the long term. If goes like this and it is mathematically correct. If you start with a penny and double what you have each day, on the 31st day, you will have $21,474,836.48! I know it doesn’t sound possible, but it is. Even on the 20th day, the amount is only $10,485.76 with only 11 days left. And this is where it begins to become impossible to continue the growth. The same is true for businesses.

Think about it in these terms. If a business had $6.92 billion in sales in 2004 and increased those sales to $74.45 billion in 2013, it would represent an exceptional rate of growth; but, it would be conceivable that it could happen. However, for the same business to continue to grow at the same percentage rate for the next 9 years would require that the sales grow, not by the $67.53 billion as it had for the past 9 years, but by $725.88 billion! The sales growth in dollars would have to increase by 11-fold simply to maintain the same percentage rate as the previous 9 years.

Analysts and investors tend to fall in love with previous figures when it comes to rising sales dollars and percentage growth figures over past years and forgot that sales dollars continuing to only rise at the same pace in the future will cause the growth rate in percentage terms to collapse. When the growth rate percentage begins to decline in the results actually being reported, investors flee in panic and stock prices can fall far more and faster than most shareholders care to imagine. Generally, the analysts are the last ones to figure it out and change the recommendations on the stock. As I said in the first installment. Analysts don’t get fired for being wrong with the crowd, they get fired for being wrong all alone.

When analysts are wrong with the crowd about a business that was formerly growing sales at the kind of exponential pace like the one discussed above, the valuations assigned to the business by the market and its herd mentality can drive values to unbelievable heights. Businesses in these situations can sometimes trade at absurd valuations like 291 times the current year’s projected earnings when the consensus analysts’ projections earnings growth rate for the next five years is only around 32% per year.

Just Because It Sounds Crazy Doesn’t Mean It Isn’t True

Just like the compounding value of a penny over 31 days sounds completely ridiculous but is true, the absurd valuation of a publically traded business I have described above is true as well. The numbers I have used to describe its current valuation and results are real as well. Even more, the business is a name known to just about every person in America and large numbers of others all around the world. The business is Amazon.com Inc. (NASDAQ:AMZN).

Amazon.com currently boasts a market capitalization of 159.31 billion and reported sales of $74.54 billion for 2013. These are very impressive numbers. So much so that among the 29 analysts covering the stock 21 currently have it rated as a “strong buy”, 3 have it rated as a moderate buy and 5 have it rated as a hold. Not a single analyst covering this stock rates it below “hold”. Here is a business that is already selling $74.45 billion of product/year that is trading at a price to earnings multiple of 290.92 times projected 2014 earnings?

To make this situation even more ridiculous, the average net profit margin for Amazon over the last five years is a miniscule 1.7%. Just so you don’t think I used the five-year average net margin because the business is showing signs of improvement in the recent margins, the one-year net margin figure is 0.38%. If Amazon is able to return its net margins back to the five-year average of 1.7%, it would generate enough money from net margins to pay off investors in just under 59 years. Would anyone care to argue that this is in any way a reasonable valuation for any business? Well, I guess I should have asked if anyone other than the analysts who cover the stock would like to make the argument. 24 strong and moderate buy ratings on a stock trading at 291 times their own earnings projections for the current year? I wonder if the “strong buy” recommendation makes them feel compelled to plow their own “hard earned money” into Amazon stock at these levels? This makes it a little more clear why we don’t see the “customers’ yachts” I asked about in the first installment, doesn’t it?

You Always Have To Finish The Job

Just as I did in the first installment, I want to illustrate that not all the “hot names” on Wall Street run a business that returns value to the shareholders just because they carry a big price tag and have a media darling like Jeff Bezos as a CEO.

While Amazon carries, what appears to be a reasonable debt/equity ratio of 30%, it only generates enough cash to cover the interest payments 4.63 times over and also pays no dividend to its shareholders. But, to be completely honest, there are other metrics to consider when determining value being returned to shareholders.

Returns on equity, assets and capital are three excellent measures by which investors can judge the ability of a company’s management to reward shareholders by increasing the overall value of the business. In the regard, Amazon’s respective 5-year annual returns of 10.6%, 3.7% and 9.1% make its current market valuation seem to be not much more than a poor joke. Unfortunately, it is a joke that is going to make a great many shareholders much poorer as well when the market comes to its senses.

If Amazon were to trade at a reasonable valuation of one times its projected earnings growth rate multiplied by 2015 estimated earnings for 2015, the share price would fall by 74% to around $90. I would imagine by the time it reached that level, at least a few of the analysts that love it so much at $346 would begin to reconsider what you should do with your money. By the time the last disgruntled shareholder finally sold at around $60, the value minded people like me would be enticed to buy their shares.

Final Thoughts And Conclusions

I don’t have a crystal ball so I can’t tell you when the share price of Amazon will return to something resembling a reasonable assessment of its fair market value. I don’t need a crystal ball to know that it will return there are some point. I have also been around long enough to know that it will happen when virtually no one expects it and the fall will not end until everyone is convinced that the business no longer has any value. That is when the long-term value investors finally get up off their collective butts and begin to take action.

The when doesn’t matter to a value investor. I am not selling the shares short so I don’t care when the price correction might come; I just know with great certainty that my money will not be caught in the avalanche of selling when it does.

Amazon serves a valuable role in providing consumers with convenient access to just about any product you can think of at some of the best prices available in the world. I am thrilled that the business exists and I make purchases from them on a regular basis. I just don’t think the stock is a compelling investment opportunity from the long perspective and I have no way of predicting when the shares might move to a more reasonable valuation which precludes me from selling the shares short. When in doubt, I don’t lose money if I sit it out.

About the author:

Ken McGaha

Ken McGaha has been managing his own investment portfolios for over 25 years.

He is a full-time copywriter as well as a freelance contributor to several investment related websites.

Ken also prepares analysis pieces of individual stocks on a contract basis for other individual investors.

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